Financial Committee Investment Recommendation v1.1

 

BACKGROUND

 

Several members have expressed apprehensions about the current investment policy (intended to preserve the Abrams endowment for 20 years): poor returns; exposure to excessive interest rate risk; and, lack of diversification.  In actual fact, the total annual return of the endowment portfolio, which is completely invested in the Vanguard GNMA fund, averaged 3.57% from 2003 to 2006; note that this four year period is the worst performance of the GNMA fund in 15 years.  Members who felt that the endowment should help future bridge players warned that unless the GNMA fund rose to historical total annual returns of 8.5%, the endowment would be exhausted in less than twenty years.

 

A Financial Committee was formed to examine these concerns and, if found valid, develop an investment goal, policy and specific investment guidance for SCBC (Unit 550). The Financial Committee participants were:

·          Vicki Kuhlmann

·          Jeff Belden

·          Nancy Wainer

·          Don Seldeen

·          Charlie Pender

·          Sam Badawi

·          Ken Llacera

 

Although not unanimous,  the Financial Committee did find the concerns expressed valid and proceeded to develop a set of recommended changes in the SCBC investment goal, objective and policy.  The recommendations below are endorsed by all but one of the committee participants.

 

INVESTMENT GOAL

 

Committee member goals for the endowment varied; here is a summary of the goals expressed:

·          Provide an inflation-adjusted portfolio value at the end of 20 years (dollar amount equal to today’s value, approximately $577,000)

·          Conservatively invest to preserve capital; 100% fixed instruments (basically, no change to current investment goals or policy)

·          Change the investment policy to ensure the endowment lasts for 20 years

 

A question was raised about what Dolores Abrams would want if she were on the committee.  Bob Vatuone had handled her estate and said that he thought she would be pleased to know the club is working to extend her endowment to the future bridge players of Santa Cruz county. He also stated that the endowment is “free and clear” in perpetuity.

 

The committee recommends SCBC adopt a financial goal that is likely to provide an inflation-adjusted portfolio value after 20 years.

 

INVESTMENT POLICY

 

In order to achieve the proposed goal, the committee recommends the following investment policy:

·          Balanced allocation including equities

·          Minimize the risk to capital

·          Broad diversification

·          Very low investment management expenses (under 1%)

 

The committee did not find general investment advice that suggests it can achieve its goals by solely investing in the GNMA fund. Further, it could not find forecasts predicting that the GNMA fund is likely to obtain historic performance results over the next five years. These findings substantiated the concerns expressed earlier by club members regarding the investment policy.

 

INVESTMENT OBJECTIVE

 

Using the Scenarios tab in the “SCBC Portfolio Manager . xls” spreadsheet, which is an integral part of this report and attached for your review and use, the committee studied several financial scenarios for SCBC over a twenty year time horizon, using the following assumptions:

·          Any change in the number of tables would not materially affect the profit/loss of SCBC

·          It is unlikely there are additional sources of income available to SCBC which could substantially reduce the total return required of the portfolio. (The spreadsheet allows modeling additional revenue, but no one has suggested a pragmatic approach to generating such revenue. Nonetheless, every effort should be made to investigate alternative sources of revenue.)

·          A realistic inflation rate for SCBC expenses (although changeable in the spreadsheet) can be estimated by using the increase in rent (12% every 5 years) over the twenty year period, which has been annualized to 2.25% for computational simplicity

·          Other expenses would increase by no more than the inflation rate (reasonable based on the last four years history)

·          Portfolio mechanics: Dividends and income are reinvested automatically; 25% of the total portfolio is set aside for paying expenses and does not generate income in the model (in the real portfolio, some portion of this sum will generate income); the portfolio is rebalanced annually.

·          The Club Owners would increase table fees in 2007 and again in ten years, giving SCBC $3,600 this year and an additional $3,600 in ten years (these amounts and frequency may be changed in the spreadsheet)

 

Note: It is recommended the Unit negotiate with the landlord well before the next rental increase for a smaller percentage increase and work with the Club Owners for a greater share of any future increase in table fees.

 

Using these assumptions, a 9% annual return is calculated as necessary to provide an inflation-adjusted portfolio value of approximately $577,000 after 20 years.

 

Therefore, the recommended investment objective is to create a conservative, balanced portfolio that meets the SCBC policy and generates a 9% return.

 

INVESTMENT PROGRAM

 

A majority of the committee believe that diversification should be achieved by first selecting specific allocation percentages across asset classes. The first table below shows the asset class allocations.  Rather than invest in a single fund of funds which has an asset allocation similar to those selected recommended, e.g. Vanguard’s Life Strategy Moderate Growth, the committee proposes SCBC allocate it’s portfolio across a number of funds. The recommended portfolio uses Vanguard index funds, which have extremely low management fees; the suggested Vanguard portfolio has a weighted-average management annual fee of 0.23%.   The Vanguard index funds selected are closely aligned to the associated asset class which allows SCBC to better maintain target allocations.  The Allocation#2 tab in the spreadsheet shows the asset class allocations and the specific Vanguard funds which meet our criteria.

 

The committee also felt that SCBC should be 50% invested in the new allocation by the end of June, 2007 and 100% invested in the new allocation by mid-December, 2007.  

 

Operational note: Vanguard is the leader in index funds and since the SCBC endowment is 100% invested in the Vanguard GNMA fund, the committee strongly recommends moving the entire portfolio to Vanguard and closing the Schwab account. Such an arrangement allows the exchange into the new funds without charge to SCBC.  After meeting each fund’s minimum investment, typically $3000, monthly dollar cost averaging is suggested as the technique to complete the conversion to the new allocation.

 

The committee’s investment recommendation is based on the objectives and goals agreed on by the committee in combination with specific advice from several sources:

·       The guidance from FundAdvisors.com for selecting the “Ultimate Buy-And-Hold Portfolio” and the suggested Vanguard balanced model portfolio, modified to meet SCBC’s objective and policy. (See the entire article at http://www.fundadvice.com/articles/buy-hold/the-ultimate-buy-and-hold-strategy.html)

·       The specific asset and fund allocation used within the Vanguard STAR fund and more loosely on the Vanguard Life Strategy funds

·        In-depth personal study of long-term financial investing by several of the committee’s members

·        A recent review of a similar portfolio by a professional financial planner

·        Personal experience and implementation of using index funds for retirement investing

 

CONCERNS AND ISSUES

 

The portfolio suffers negative return(s): This situation will definitively occur several times over the 20 year time horizon.  While the chosen allocation is “conservative” it exposes the endowment to somewhat more total risk than the current, 100% GNMA bond fund allocation.  The committee examined a similar fund (STAR) and its annual performance over the last 15 years of available data (see the Compare Funds tab in the spreadsheet). While STAR had two years of negative returns, its 15 year performance is vastly superior to using GNMA: starting with a value of $370,000 and using an inflation rate of 2.25%, if the SCBC endowment had been invested in the STAR fund, it would have been $873,740 after 15 years, while had the endowment been invested exclusively in the GNMA fund, its value would be only $233,297. Both of these projections include paying expenses over the period.  Of course, results typical of the STAR fund can not be guaranteed and the recommended portfolio is not likely to perform quite as well as the STAR fund over a long period of time.  Additionally, forecast results (9% annual return) require that SCBC remain steady in its investment policy over a sufficiently long period.

 

If the new portfolio does have a negative return in a year, how will SCBC pay its bills?  In the current operation, the monthly interest generated by the GNMA fund covers a large portion of the SCBC expenses. The interest is not reinvested, rather it is placed into a checking account at a local bank and used to pay the expenses.  When the interest amount is less than the expenses, shares of the GNMA fund are sold to make up the difference. With the new balanced portfolio, cash for expenses will also be drawn out of a Vanguard fund, specifically the Prime Money Market Fund and placed in the local bank account. At the end of the year, the value of this specific fund will be substantially reduced and “out of balance”.  The Treasurer, as part of the annual rebalancing of the entire portfolio, “replenishes” the Prime Money Market Fund.  Note: even a bond fund like GNMA fund can have a negative total return and did in 1994.

 

How can future SCBC Treasurers figure out the target allocations?  The committee has developed a fairly simple allocation model, but with 13 funds, calculating the number of shares to achieve rebalancing can be laborious. The committee has provided within the supplied spreadsheet the functionality to automatically generate the number of shares to buy and sell for each fund at literally the push of a button.  In the provided spreadsheet, the rebalancing function is active so that you can try it out for yourself.

 

After a year of poor performance, a new Board might reallocate the portfolio to more conservative funds or abandon the asset allocation model:  The Board must recognize that the recommended investment approach is a long-term strategy that frees the Board from short-term management of the investment portfolio. It is based on a significant history of the market, which has ups and downs when viewed on a short-term basis. The committee strongly recommends that the Board adopt a motion to maintain the asset allocation in the portfolio, with changes only for rebalancing, correcting operational issues and or refining fund selection, for a minimum of five years.

 

How did the committee arrive at 9% as the long-term annual return for the recommended portfolio? The model portfolio was entered into a financial planning tool that Vanguard provides. This tools uses more than 40 years of market data to do simulations, which are primarily based on asset class rather than specific funds. The tool projects a 9% annualized return for this type of portfolio. Vanguard funds similar to the recommended portfolio were also examined to determine if the 9% was a reasonable expectation. Here are their “since inception” returns (with the year of inception):

·          Life Strategy Moderate Growth: 9.81% (1994)

·          Life Strategy Conservative Growth: 8.80% (1994)

·          STAR: 11.12% (1985)

·          Wellesley: 10.74% (1970)

 

Isn’t investing in equities risky?  Every investment and every investment policy involves risks, both short-term and long-term. In addition there are various types of risks. The recommended policy means the SCBC portfolio can and will lose money in certain years.  However, consider this: due to inflation, currently the Unit’s endowment is losing money now even though it is invested solely in bonds because the return is so low. The bond fund is subject to several kinds of risks, including interest rate risk and redemption risk. In other words, our current investment policy contains risk, perhaps more than most people realize.  The recommended strategy is said to be one of the best approaches to long-term investment success.  By utilizing broad diversification across major asset classes, SCBC will be exposed to much less risk when compared to investing in individual stocks and bonds. The recommended strategy does not involve investing in individual stocks or bonds; the recommended portfolio only invests in broad market indexes (with the exception of the Prime Money Market Fund, the GNMA bond fund and the PRIMECAP Core fund, which is a highly diversified fund in itself).

 

Are Directors liable if the investment strategy do not perform to expectations?  It is highly unlikely, given the portfolio amount, that any legal action would be brought, unless fraud or gross negligence is found. The Directors have fiduciary responsibility for managing the club’s finances and endowment. In other words, not taking any action could also subject the Directors subject to a suit as could making a considered, carefully researched, investment decision.  In any case, the D&O insurance fully covers our decision(s) in this matter.  

 

 

Change Log

      v1.1

1.       Corrected portfolio values after 15 years if invested in STAR versus GNMA. This calculation originally did not set aside 25% of principal for contingency and expenses. STAR still was $640,000 larger than GNMA after 15 years.

2.       Removes PRIMECAP Core fund; adds Small Cap Value Index fund. These changes allow a purer allocation to the asset classes chosen by the committee and increase the percentage allocated to Value and small caps, which were under-represented. As a result, the management fee weighted-average was lowered to .23%.